The multinational enterprise as an internal market system

International Business Review 15 (2006) 253–277 www.elsevier.com/locate/ibusrev

The multinational enterprise as an internal market system* Daniele Cerrato * Dipartimento di Scienze Economiche e Sociali, Universita` Cattolica del Sacro Cuore, Via Emilia Parmense 84, 29100 Piacenza, Italy Received 13 November 2004; received in revised form 12 December 2005 and 12 February 2006; accepted 13 February 2006

Abstract This paper builds on Birkinshaw’s model of multinational enterprise (MNE) as an internal market system [Birkinshaw, J. (2000). Entrepreneurship in the global firm. London: Sage]. This model addresses the issues related to the emergence of market-based mechanisms of coordination within the MNEs and the strategic decisions that affect internal competition. Birkinshaw argues that subsidiaries simultaneously participate in three different internal markets within an MNE: a market for intermediate goods and services, one for charters and another for competencies and practices. The goal of the paper is to expand Birkinshaw’s concept of internal market and analyze the logic behind internal competition by considering more fully existing literature and developing an organizing framework to position such a model within that literature. There is specific focus on discussing how the internal market model relates to modern network-based configurations of the MNE. In addition, the study shows that factors affecting the extent to which each of the three internal markets is established can be better understood if we link such a model to the contributions developed by three mainstreams of research: internalization theory, resource-based view and organizational learning literature. q 2006 Elsevier Ltd. All rights reserved. Keywords: Internal markets; Hierarchy; Network; Subsidiaries

1. Introduction This paper analyzes Birkinshaw’s (2000) model of multinational enterprise (MNE) as an internal market system. This model addresses the issues related to the emergence of * An earlier version of this paper was presented at the 29th Conference of the European Academy of International Business (EIBA) on ‘MNC as a Knowing Organization’, held at the Copenhagen Business School, 11–13 December 2003. * Tel.: C39 0523 599341; fax: C39 0523 599303. E-mail address: [email protected].

0969-5931/$ - see front matter q 2006 Elsevier Ltd. All rights reserved. doi:10.1016/j.ibusrev.2006.02.001

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market-based mechanisms of coordination within the MNEs as well as the strategic decisions that affect the working of internal markets. By splitting the internal market into three (one market for intermediate goods and services, one for charters, and one for competencies and practices), Birkinshaw’s framework can be a useful starting point for analyzing the logic behind the way internal competition works in a modern MNE. However, the theoretical foundations and implications of the model are not discussed in Birkinshaw’s book. The author himself states that the framework of the MNE as an internal market system has not been widely developed. He recognizes that ‘it is not yet clear if this approach will yield any valuable insights’ (Birkinshaw, 2001, p. 388). Exploring this is within the scope of this paper, which is structured as follows. Section 2 briefly describes the shift from a hierarchical to a network-based configuration, which characterizes recent theoretical perspectives of the MNE. In the 1990s, research, in particular, on network theory and resource-based view provided new insights for the analysis of strategies and configurations of modern MNEs. In spite of the differences in their contributions to the theory of the MNE, these more recent theoretical perspectives share a common emphasis on processes, decisions and patterns of capability development that take place at subsidiary level and on their influence over the MNE’s strategic behaviour and competitive advantage. Section 3 analyzes the context that the internal market model best fits. As the strategy and organization of MNE have changed considerably over the last 20 years, the explanatory power of the different models is to be evaluated in close connection with the conditions in which the MNE’s activities take place. Through analysis of the essential features of market and hierarchy, this section focuses on what is meant by internal market and embodies the discussion of the model within the modern network-based view of the MNE. Building on Birkinshaw’s identification of three types of internal market within the MNE, Section 4 develops a set of propositions concerning factors affecting the extent to which each market is established. The thesis around which the framework is developed is that internalization theory, resource-based view and organizational learning literature provide useful contributions to the analysis of the MNE’s internal markets. Section 5 summarizes advances and limitations of this study and shows some directions for future research in the field. 2. The modern MNE: from hierarchy to network Internalization theory (Buckley & Casson, 1976; Rugman, 1981) has been the most widely adopted theory for the explanation of the existence of the MNE. Such theory draws on transaction cost economics (Williamson, 1975), which focuses on the organization of economic activity in markets and firms. Transaction cost economics argues that price system (markets) and hierarchy (firm) are the two different ways of organizing any given transaction. Markets are less than perfectly efficient because of bounded rationality and opportunism. Market failures or high transaction costs, experienced through market transactions, make hierarchy a more efficient mechanism of organizing economic activities. On the basis of these considerations, internalization theory explains the existence of the MNE as a response to imperfections in international markets. The MNE emerges as a way of coordinating activities across countries when ownership-specific and location-specific advantages combine with intermediate market imperfections (Dunning, 1981, 1988). The preference for market or hierarchy is based on the evaluation of the costs related to their governance mechanisms: the existence of the MNE will occur when the organization within the firm of interdependencies between agents located in different countries is more efficient than

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the organization through markets and when the benefits of organizing interdependencies within the firm are higher than their costs (Buckley & Casson, 1976; Rugman, 1981). In addition, internalization theorists argue that an MNE’s possession of intangible assets (such as technical know-how, marketing abilities and managerial skill) is the main determinant of foreign direct investment because of the market imperfections associated with the international transaction of knowledge-based assets. This theory was developed in a context in which the portrayal of the MNE as hierarchy reflected its actual working. The theoretical framework for the choice between market and hierarchy assumes that market and hierarchy are well-defined alternatives. However, the traditional hierarchical model became increasingly inadequate to reflect the complexity of the modern MNE (Birkinshaw & Morrison, 1995). The changes which occurred in the 1980s and 1990s led to the collapse of such a clear distinction and, consequently, to the emergence of hybrid configurations of MNEs, which contemporarily adopt market-like and hierarchy-like mechanisms and structures. Hennart’s (1993, 2001) distinction between method of organization (prices and hierarchy) and institutions (markets and firms) is useful for capturing the meaning of the increasing overlap between the two alternatives described above. Markets and firms adopt both methods of organization, but to different degrees as firms rely more on hierarchy, while markets mostly adopt prices. Organizational models that fail to conform to traditional configurations of markets or hierarchies have increasingly become the object of research particularly over the past decade by both economists and sociologists. Recent theoretical perspectives indicate that, far from being a centralized hierarchy, MNE is an interorganizational network (Ghosal & Bartlett, 1990) of loosely coupled nodes, characterized by their own unique resource and capability profile. The conceptualization of MNE as ‘heterarchy’ (Hedlund, 1986), ‘differentiated network’ (Nohria & Ghoshal, 1997), ‘transnational solution’ (Bartlett & Ghosal, 1989) emphasizes this characteristic. Scholars argue that network forms of organization represent an alternative configuration with its own logic and a number of specific advantages (Podolny & Page, 1998; Powell, 1990). In this approach the configuration of the MNE moves from a hierarchical perspective, in which all the strategic activities fall into the business domain of the parent company, towards a configuration which recognizes the existence of centres of excellence (Holm & Pedersen, 2000) and specialized knowledge in multiple nodes of the MNE, linked to one another by flexible governance mechanisms. Therefore, the traditional asymmetric dyadic relationship between parent company and subsidiary is replaced by a more complex network of multiple interorganizational relationships within the MNE. Not only internal but also external relationships qualify the MNE network. Recent literature about subsidiary strategy has emphasized the importance of subsidiary embeddedness in the knowledge networks of host countries (Andersson, Forsgren, & Holm, 2002; Andersson, Forsgren, & Pedersen, 2001). Specific relationships with local actors (suppliers, customers and other stakeholders) give a measure of external embeddedness (Andersson & Forsgren, 2000) and enable identification of the resource profile of each subsidiary. The local environment in which each subsidiary is embedded affects its pattern of growth by raising both constraints to its activities and opportunities in terms of potential for resource acquisition and broader strategic options. As Ghosal and Bartlett (1990, p. 606) point out: ‘the uniqueness of the MNC as an organizational form arises from the fact that its different constituent units are embedded in different national environments in which the structures of these relational networks can be and are often very different’.

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The emergence of a network-based model of modern corporation is related to two major needs that modern corporations perceive: flexibility and more intense organizational learning. These are not related to strictly efficiency-based explanations of the prevalence of one form of governance over another. Firstly, in a context characterized by greater environmental uncertainty and the need for flexibility, coordination of activities cannot be obtained by relying exclusively on authority. Hierarchical boundaries partially lose their value as a coordination mechanism. Network-based organizations respond more flexibly and rapidly to changes than hierarchies as they are more easily modified. Secondly, network forms of organizations present significant learning benefits (Hamel, 1991; Powell, 1990; Uzzi, 1997). Learning is a social process based on interactions which are fostered by connections within networks. The subsidiaries (nodes) of the modern MNE are embedded in networks, which enhance learning (Schmid & Schurig, 2003). In a transaction cost perspective the reduction of transaction costs is the key issue for analysis of the governance of economic activities. On the contrary, from a learning perspective or a strategic management perspective, the emphasis is not so much on the reduction of transaction costs but on the benefits deriving from greater learning and greater adaptability (than hierarchies) to environmental changes. Moreover, network relations assure greater communication and richer information than arms-length contracts and greater autonomy compared to hierarchy (Podolny & Page, 1998). Analysis of the MNE patterns of development of firm-specific advantages (FSAs) can largely draw on the resource-based view, which emerged as the dominant paradigm in strategic management studies in the 1990s. The question that resource-based view can help address is how an MNE can extract rents from its set of firm-specific resources. The MNE’s competitive advantage relies on its capability to accumulate, exploit, recombine, and innovate its set of firm specific resources as well as transfer such resources to the different nodes of its extended network.1 However, the original theoretical framework of the resource-based view has been revised in recent years, so as to extend the analysis of resources, which was initially based on the internal endowment of a single firm. The relational view of competitive advantage (Dyer & Singh, 1998) and contributions drawing on network theory indicate that competitive advantages and patterns of growth are related not only to the resources that firms can individually develop, but also to the network resources they can leverage (Gulati, Nohria, & Zaheer, 2000). Therefore, a distinction cannot be easily made between ‘totally internal’ and ‘totally external’ ways of developing resources and capabilities because ‘hybrid’ (between internal and external) modes of resource development are emerging. As is discussed in Section 3, in the internal market model, not only does the distinction between hierarchy and market become more difficult to define, but also the difference between internal and external partially loses its traditional meaning.

3. A framework for the analysis of the internal market system The view of the MNE as an internal market can be useful to take into account the important changes that MNEs are experiencing today. Birkinshaw (2000) moves from the largely 1 Particularly, knowledge-based resources fit better the condition of imperfect mobility (Peteraf, 1993) which resourcebased view has identified as a potential source of competitive advantage. According to a broad definition, they include all those resources, which are not protected by property rights, but by knowledge barriers (Miller & Shamsie, 1996).

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consolidated recognition that, given the obsolescence of the traditional hierarchical model of MNE, new modes of coordinating activities across countries are emerging. In this context the MNEs are ‘recognizing the need to develop more flexible configurations to make them more responsive to changing market demands’ (Birkinshaw, 2000, p. 111). Specifically, the context that the internal market model fits is characterized by: (1) The importance of subsidiary initiatives and endorsement of resources and capabilities, including those deriving from the subsidiary embeddedness in the host country environment. (2) A greater dispersion of the value-adding activities of the MNE and the emergence of new, hybrid (between markets and hierarchy) governance mechanisms of economic interdependencies across countries. The conditions sub 1 and 2 represent two sides of the same coin: the increasing dispersal of value-adding activity across subsidiaries is related to the greater amount of specific resources they control. Such conditions imply a greater emphasis on subsidiary managers as free agents, rather than mere players of the roles imposed by the parent company. Subsidiaries can assume a broad variety of roles (Bartlett & Ghosal, 1989; Birkinshaw & Morrison, 1995; Jarillo & Martinez, 1990). Research about world product mandate (Roth & Morrison, 1992; Rugman & Douglas, 1986), charters (Birkinshaw, 2000; Birkinshaw & Hood, 1998) and the emergence of centres of excellence (Holm & Pedersen, 2000) shows that a subsidiary provides a significant contribution to the MNE competitive achievements, in terms of local responsiveness, global integration and learning activities. The evolution of the MNEs over the last two decades can be summarized as a shift from a prevalence of parent company firmspecific advantages (FSAs) to a mix of location-bound and nonlocation-bound FSAs across the MNE network. In addition, greater exchanges of products and knowledge flows enhance the interdependence between a subsidiary and the rest of the MNE. Bartlett and Ghosal (1989) propose a contingency approach for the selection of specific coordination and control systems within the transnational corporation. Rugman and Verbeke (1992) argue that the transnational solution is consistent with the predictions of transaction cost theory, which has already recognized the importance of a contingency approach (Buckley, 1983). From this perspective ‘the MNE should try to develop an optimal mix between the “visible hand of managed integration” and the “invisible hand”, using internal market mechanisms.[and].the mix will vary according to the degree to which interdependencies between the different operations can be measured through prices, and the degree to which corporate headquarters possess detailed knowledge of subsidiary operations’ (Rugman & Verbeke, 1992, p. 769). The matrix in Fig. 1 shows the main determinants of interdependence among the units of the MNE network. The vertical dimension indicates the subsidiary’s role. It represents the importance of the subsidiary’s strategic initiatives and resources in terms of contribution to the MNE’s strategic behaviour and competitive advantage. The classic hierarchical, centralized model of MNE, where most strategic activities are carried out by the parent company, falls in the upper side of the matrix while the modern MNE, characterized by the emergence of centres of excellence and by multiple islands of dispersed and specialized knowledge and competence, should be positioned in the lower side. The horizontal dimension shows the strategic focus of the MNE. Specifically, it classifies the MNE’s strategy on the basis of the focus on an integrated worldwide strategy. A greater focus on integration implies

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Focus on integration

Low

Importance of subsidiary resources and initiatives

High

1

2 Low interdependence Coordination based on simple financial controls and supervision by the parent company

Low

Moderate degrees of interdependence Unidirectional influence and strategic control from parent company to subsidiary

4

High

3 Moderate degrees of interdependence

High interdependence

Coordination of independent businesses based on market -like mechanisms and financial link ages

Complexity of coordination based on a wide array of mechanisms

Fig. 1. Interdependence in the MNEs.

a greater interdependence of activities carried out by the subsidiaries and requires more numerous linkages in terms of exchanges of products/services and flows of knowledge. The cases in quadrants 1 and 3 are the two extremes: quadrant 1 is the case of low interdependence among subsidiary activities because most strategic activities, competencies, and choices are centralized. Moreover, as strategy pays little regard to the implementation of an integrated worldwide strategy, coordination by the parent company is not a critical task and mostly relies on simple tools of financial control and supervision. Quadrant 3 is the case in which an integrated worldwide strategy builds on the coordination of differentiated contributions and dispersed activities by multiple centres of competence. Interdependence is multidirectional as significant flows of products and knowledge link each subsidiary to the rest of the MNE. Therefore, coordination needs are higher and imply the adoption of an expanding array of control mechanisms so as to enhance horizontal linkages among multiple centres. Quadrants 2 and 4 are cases of intermediate level of integration: in quadrant 2, in spite of the need for coordination due to the focus on integration, interdependence is merely unidirectional because the headquarters provides strategic leadership and control over subsidiaries and centralizes strategic activities and competencies. Quadrant 4 depicts the case where the MNE consists of a set of multiple independent strategic centres, which are important for the overall success of the MNE. However, coordination is largely based on market-based mechanisms and financiallybased organizational linkages, as a consequence of little or no concern for the implementation of an integrated worldwide strategy.

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3.1. Why internal? And why market ? The internal market model within the network-based perspectives of the MNE On the basis of the prevalence of firm-like or market-like coordinating mechanisms, Birkinshaw identifies three archetypes of the MNE: ‘the “traditional” manufacturing firm [hierarchy], such as GM, which coordinates both its own operations and its suppliers on a central basis; the “virtual” firm, such as Nike or Dell, which outsources large parts of its business system; and the “internal market” firm, such as ABB, which continues to own most of its business system but coordinates it through a more bottom-up process’ (Birkinshaw, 2000, p. 115). The classic, hierarchical model of MNE, based on high degrees of centralization and centrality of the parent company’s role in the coordination of differentiated activities, has been the main object of analysis of early internalization theory. At the opposite extreme of the continuum, the ‘virtual corporation’ outsources most of its activities. This model results from the most widespread dispersal of activities across countries. In the virtual corporation, coordination of dispersed operations and value-adding activities rely on purely market-based mechanisms. From a perspective focused on firm-specific advantages, the virtual corporation is the model that best fits the case in which the MNE’s competitive advantages primarily consist of multiple location-bound FSAs, while the traditional hierarchical corporation is based on the centrality of a home-country FSA. In the latter model, the dominant pattern of FSA exploitation is represented by the transfer of nonlocation-bound FSAs from the home country to the host country through a process in which the parent company determines the roles played by subsidiaries as mere ‘implementors’ of headquarters strategy. In the internal market system, coordination of dispersed value-adding activities in different countries is largely based on market-like mechanisms. However, the headquarters still plays a significant role in terms of definition of the ‘rules of the game’ (Birkinshaw, 2000, p. 116) concerning the working of the internal market and the governance of the exchanges of products/services and resources mobility.2 The conceptualization of the MNE as an internal market system shares with recent literature the shift from the classic hierarchical model to a network-based configuration (Bartlett & Ghosal, 1989; Hedlund, 1986; Nohria & Ghosal, 1997; Prahalad & Doz, 1987). As Birkinshaw himself states, many of the concepts related to an internal market view of the MNE can be found in frameworks like Ghoshal and Bartlett’s (1990) interorganizational network or Hedlund’s (1986) heterarchy. However, this thesis is not widely discussed in the original formulation of the internal market model. Such a formulation of the internal market model needs further developments so as to embody the discussion of this model within the view of the modern MNE as a network-based entity. In this section, I provide some arguments to support this assertion. The distinction between the three archetypes has to be grounded on a deeper analysis of the essential features of a market and a hierarchy in the context of the MNE as well as of the difference between internal transactions within the firm and pure market exchanges. Birkinshaw’s concept of internal market is quite different from the traditional view of internal market. A conceptualization based on the distinction between internal market and hierarchy is 2

‘In some respects.[internal market and virtual corporation] are quite similar, because both involve the use of market systems to facilitate coordination; but they differ in one important respect, namely that the virtual model involves the coordination of multiple independent firms whereas the internal model involves coordination within a single legal entity’ (Birkinshaw, 2000, p. 115).

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not consistent with the framework developed by internalization theory, according to which internal market is hierarchy, as opposed to (external) market.3 However, the difference between the two perspectives is due to the different context in which the modern MNE operates, rather than a misinterpretation of the concept of internal market. As explained above (see Section 2), early internalization theory assumes a clear distinction between hierarchy and market or, in other words, between internal market and external market. The question of the boundaries of the firm is at the core of the transaction cost theory, which explains the existence of firm as form of governance distinct from market transactions (Williamson, 1991). A firm implies a structured set of relations where planning prevails over contracting. Markets involve multiple exchanges, multiple buyers and sellers and, as a result, a degree of competition (Hodgson, 2002). Markets assure coordination through instantaneous monetary exchange while hierarchy does it through authority.4 Hierarchy responds to the need to create stable structures of the business relations and resource allocation so as to reduce uncertainty in work dynamics. In other terms hierarchical control reduces uncertainty in the process of acquiring inputs for economic activities. Control is a process typically associated with hierarchical authority (Lomi, 1997), while market exchanges are typically associated with decentralized decision-making and flexibility. However, the rigid distinction between hierarchy and market can be considered as an oversimplification (Hodgson, 2002). In the modern network-based configuration of the MNE such distinction collapses. The emergence of concepts like internal markets within firms, ‘quasimarkets’ or ‘quasifirm’ (Eccles, 1981), network forms of organization and firm-market hydrid (Cheung, 1983; Menard, 1995; Williamson, 1985) prove that the consolidated rigid distinction between the firm and the market is somewhat old-fashioned. The issue is not only (and not so much) what hierarchy or market are, but also what ‘internal’ and ‘external’ mean. Those boundaries become porous because the firm is deeply embedded in networks with other organizations that it is difficult to distinguish what is inside and outside. Coherently with this perspective, in the internal market model flows of products and services involve buyers and sellers both inside and outside the MNE network.5 Typically the difference between market and firm builds on the idea that by internalizing a transaction a firm moves from a situation in which it has no control over a transaction to a situation of full control. However, two considerations suggest that this distinction may be too approximate. First, internal relationships, too, have market-like characteristics. As a dispersed power structure characterizes the MNE network, the headquarters cannot exert full control over internal transactions as typically described in hierarchy. On the other hand, internal market model is not synonymous with virtual corporation, basically because the working of internal markets within an MNE cannot be assimilated to a market tout court. In other words, internal transactions are not exchanges. Otherwise we would neglect the role of the headquarters in establishing the rules of the game. 3 An evidence of this difference is that Rugman’s book, one of the most influential contributions to internalization theory, is entitled ‘Inside the Multinationals: The Economics of Internal Markets’ (italics added). 4 ‘In a pure market, relations are not enduring, but episodic, formed only for the purpose of a well-specified transfer of goods and resources and ending after the transfer. In hierarchies, relations may endure for longer than a brief episode, but a clearly organized, legitimate authority exists to resolve disputes that arise among actors’ (Podolny & Page, 1998, p. 59). 5 ‘Under an internal market model there might be two or more internal suppliers and customers, and there might be several external suppliers or customers as well’ (Birkinshaw, 2000, p. 117).

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Internal negotiations and transfer of resources are common within an MNE but competition and rivalry do not necessarily imply competition in a market because hierarchy-like mechanisms and specifically a set of administrative rules and procedures defined by the headquarters affect competition itself. Consider the example of internal capital market and competition among subsidiaries for the budget allocated by the parent company (Mudambi, 1999). The way such competition and rivalry work is not necessarily the working of a true capital market (Hodgson, 2002). Similarly, periodic revision of world mandates and resource allocation follow the rules set by the headquarters rather than just a pure market mechanism. What characterizes internal markets within an MNE is the existence of a strategic decision making centre which affects the way those transactions are set up and performed. Hence, not only coordination mechanisms but also the role of the headquarters should be considered in order to identify different archetypes of MNEs. The headquarters can have an interest in restricting or widening the extent to which an internal market is established. Again, a networkbased approach provides a useful contribution for understanding the importance of headquarters’ role. As the MNE nodes configure loosely-coupled systems, the lack of hierarchical structures may negatively affect the network stability and cohesion. The headquarters has to prevent subsidiaries from pursuing strategic initiatives that diverge from the MNE’s strategy. In addition, the headquarters assesses the value of strategic resources distributed across the MNE network and coherently affects their mobility so as to assure that resources are made available where they are actually necessary. These tasks qualify the headquarters’ role in terms of governance of interdependencies within the MNE network, rather than in terms of hierarchical control. Setting up the rules of internal competition is a critical part of this role of governance. In addition, the working of the internal market system shows some similarities with the flagship model developed by Rugman and D’Cruz (1996, 2000). This model aims to provide a contribution to the analysis of the interfirm networks in which the MNE is involved. The model proposes an alternative governance mechanism to market and hierarchy as a result of asymmetric control by the flagship firm over the strategic actions of the network (Rugman & D’Cruz, 1996). Flagship model and internal market system share a common emphasis on the network-based approach to the analysis of the MNE. However, a significant difference exists between the two perspectives. The flagship model keeps the MNE as the hub firm in a set of key suppliers/customers/partners relationships. This model focuses on centralized decision making and strategic guidance by the hub firm and neglects the importance of subsidiary-specific advantages and initiatives to the strategic behaviour of the central firm. The strategic influence is unidirectional, from the flagship firm to its network partners, even though it is not a hierarchical relationship, but based on asymmetric strategic control.6 4. Disentangling the internal market model: market for intermediate goods and services, market for charters, market for practices and capabilities Birkinshaw (2000) disentangles the concept of internal market through the analysis of three markets, which jointly identify the model: market for intermediate goods and services, market for charters, and market for practices and capabilities (see Table 1). 6 Strategic asymmetry ‘is meant to imply that the flagship exercises control over the strategy of its network partners, while they have no reciprocal influence over the flagship’s strategy’ (Rugman & D’Cruz, 2000, p. 117).

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Table 1 Three types of internal markets Type of market Market for

Intermediate product or service

Charter

Capability or practice, intangible resources

Main question in the establishment of the market

To what extent does MNE want to internalize the existing market system?

Where does MNE want each value-adding activity to take place?

How can leading-edge capabilities and practices be efficiently identified and transferred?

Role of subsidiary

Compete with internal and external competitors in delivery of product or service to the next stage of the value chain

Compete with internal and external competitors for new and existing charters

Actively seek out ‘suppliers’ of practices, and make practices available to other units

Role of headquarters

Define extent to which each stage of value chain will be internalized and customer’s freedom to select among competing alternatives

Define extent to which new and existing charters will be competed for, and extent to which external bids will be accepted

Define systems that help maximize flow of practices inward and internally, but which limit the outward flow of practices (to external entities)

Adapted from Birkinshaw (2000, p. 118).

Birkinshaw’s main insight is that analysis of the three markets helps us understand strategic decisions both at subsidiary level and corporate level. However, he does not largely draw from existing theoretical perspectives to explain the logic behind each market and the theoretical foundations of the model remain largely undeveloped. In this section, I try to fill this gap by Table 2 Theoretical perspectives for the analysis of the three internal markets Theoretical perspectives which address the questions related to the establishment of the market

Internalization theory

Resource based view

Organizational learning and knowledge management literature

References

Buckley & Casson (1976) Rugman (1981)

Birkinshaw (1996, 2000) Birkinshaw & Hood (1998) Rugman & D’Cruz (2000) Rugman & Douglas (1986)

Gupta & Govindarajan (1991, 2000), Kogut & Zander (1993)

Factors affecting the extension of the market

Input specificity and sunk costs

Immobility of charters’ underlying resources and capabilities Subsidiary’s reputation

Tacitness and context specificity of knowledge

Uncertainty of transactions

Inefficiency related to lower incentives in case of lack of alternatives (inefficiency of the ‘captive market’) Need for flexibility

Decentralization of decision-making

Frequency and openness of communication

Number and kind of interactions due to flows of products/services Frequency and openness of communication

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arguing that the main questions related to the extent to which each of the internal markets is established can be addressed if we link such configuration to three mainstreams of research: internalization theory, resource based view and organizational learning perspective (see Table 2). The three markets are linked: exchanges of products, knowledge flows, and changes in charters are related to one another. The separate analysis of the three markets does not imply the absence of interconnections and commonalities. As discussed in the previous sections, a network-based approach represents a common platform for the study of the mechanisms which coordinate the activities of the dispersed but interdependent MNE’s nodes. However, the framework proposed responds to the need for an in-depth analysis of the logic and choices behind the working of each of the three markets. On the other hand, any model or framework (and this is not an exception) ‘by definition’ simplifies reality and ignores some factors of complexity in order to isolate a number of specific causal relationships. 4.1. Market for intermediate goods and services The basic question that Birkinshaw (2000, p. 117) asks when proposing this market is: ‘how great a degree of choice should this unit have with regard to suppliers/customers, either inside or outside the firm?’. This issue directly relates to the top management’s strategic choices. In a hierarchical integrated model, each business unit has no choice at any stage of the value chain about who it sells to or who it buys from. On the contrary, in the internal market system, each unit responsible for a step of the value-adding system has greater degrees of freedom with regard to who it sells its products and who it buys from. Though not explicitly recognized by Birkinshaw (2000), internalization theory (Buckley & Casson, 1976; Rugman, 1981) provides useful insights for the understanding of the functioning of the market for intermediate goods and services. Our answer to Birkinshaw’s question is largely grounded in that theory. In spite of the limitation of its earlier formulation,7 internalization theory proposes an efficiency-based framework that sheds light on the transactions costs associated with managing an internal market. In fact, the framework drawing on transaction cost economics (Williamson, 1975) for the governance of exchanges in external markets may also apply to the exchanges within the MNE’s internal market. Multiple paths increase all these costs associated with the internalization of transactions.8 The establishment of an internal market should be pursued to the extent that the benefits it produces are equal to the costs involved by the management of the market itself. Those costs are specific to the nature of the intermediate products and services involved. 7 As I have already pointed out, the limitation associated with early internalization theory is due to the fact that the choice between the alternatives market and firm assumes a clear distinction between the two for firm being a hierarchical monolithic, centralized corporation, while the modern MNE can be more effectively described as a network. However, in a recent work, Rugman and Verbeke (2003) demonstrate that internalization theory still provides a powerful analytical tool to understand the actual functioning of complex organizations such as the MNE’s differentiated network. 8 Buckley and Casson (1976) disentangle the costs associated with internal transactions, focusing on: the costs due to the need for high volume of accounting information; the overhead costs, related to the management of a communication system; the costs to check the accuracy and reliability of information provided by each unit managers (Rugman & Verbeke, 2003).

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High specificity of the intermediate product/service and a high level of investments needed to set up additional units producing the same input can make the duplication and the parallel working of multiple paths inefficient. Specificity refers to the ease/difficulty with which an asset can be destined to alternative uses (or transferred to a new unit within the MNE) without losing value. The level of sunk costs, i.e. the costs for implementing multiple paths and that could not be recovered if the transaction is terminated because that specific component would not have any different application (Poppo, 2003), creates disincentives to invest. All these factors create inefficiencies within the MNE’s internal market just as they do in external markets, as the logic behind the exchanges is the same. Hence, similarly to external markets, also internal markets suffer from the same failure, i.e. under-investment in specialized assets. In order to avoid this risk, investments in specialized assets should be protected by the stability of an exclusive relationship with customers be it in the context of intra-firm or inter-firm exchanges. Therefore, P1. Input specificity and sunk costs are negatively related to the implementation of an internal market for intermediate goods and services. Moreover, uncertainty in terms of difficulty in defining product/service specifications and exchange conditions increases the inefficiency of market exchanges, due to communication costs, risk for nonequitable transactions, etc. This argument can be summarized as follows: P2. Uncertainty related to market exchanges is negatively related to the implementation of an internal market for intermediate goods and services. When these conditions are relaxed, benefits deriving from the promotion of internal competition can be significant compared to the costs of establishing the market, for two basic reasons. The first is based on considerations of efficiency: exposing the MNE units to internal/external competition represents an incentive to efficiency. Benefit will be high as the absence of alternatives for a given unit may result in inefficiency, due to lower stimulus to innovate and improve. In fact, if each unit within the MNE is protected by the existence of a captive market, incentives to improvements will be low. P3. The inefficiency of the ‘captive’ market is positively related to the implementation of an internal market for intermediate goods and services. The second kind of benefit is based on the consideration that the existence of multiple choices for the production of intermediate products or services results in greater flexibility. A broader range of alternatives would be excluded in a centralized, integrated MNE. Such strategic benefits will be higher if the MNE perceives a greater need for flexibility. Generally, MNEs are seen as building value by enjoying greater operating flexibility compared to domestic competitors (Dunning & Rugman, 1985). The value of such flexibility is an intriguing question that some scholars have addressed (Kogut & Kulatilaka, 1995).9 From a strategic viewpoint, flexibility can be defined as the ability to respond to changes in the competitive environment and re-examine strategic decisions (Aaker & Mascarenhas, 1984; Young-Ybarra & Wiersema, 1999). 9 Operating flexibility is the MNE’s ‘ability to arbitrage in the real and/or financial markets by shifting factors of production across borders and by transferring resources within a transnational network’ (Allen & Pantzalis, 1996).

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A competitive advantage is related to commitment in terms of specific investments in human skills, capital equipment and other assets. However, in contexts where flexibility and attitude for strategic change are perceived as important for competition, managers have to be able to rethink their resource deployments. Relying on market-based mechanisms for resource (re)allocation is coherent with a need for flexibility. As Harrigan (1985) has noted, strategy implies a balance between focused commitments on the one hand and resource flexibility on the other. As a result, in order to understand the logic behind the restriction (extension) of the internal market, the MNE’s strategic orientation has to be considered. Strategic orientation can be described as a continuum, the extremes of which are focus on stability and preservation of existing equilibrium in the business model and, on the other hand, focus on flexibility and attitude for change. The former implies the interest of top management in restricting the internal market and preference for a centrally planned structure; the latter is more likely to occur when top management has to deal with a changing and turbulent environment, which makes it strategically relevant to have a broader range of alternatives. These considerations can be summarized in the following proposition: P4. Need for flexibility is positively related to the implementation of an internal market for intermediate goods and services. In conclusion, the decision about the extent to which an internal market for intermediate goods and services should be established builds on the analysis of a number of constraints (due to uncertainty and input specificity) as well as benefits (incentive to efficiency and flexibility). Propositions are summarized in Fig. 2. As these propositions rely on the transaction cost economics (TCE) framework, difficulties of measurement and empirical testability are not dissimilar to those which typically affect the TCE empirical investigation.10 There is a significant body of empirical research in TCE which has faced the issue of the operationalization of constructs like asset specificity, uncertainty, complexity of trading arrangements and so forth.11 These empirical works (Bergh & Lawless, 1998; Poppo & Zenger, 1999; Young-Ybarra & Wiersema, 1999) could be an important knowledge base for the operationalization of the constructs adopted in the framework proposed. Asset specificity (Joskow, 1985, 1987; Masten, Meehan, & Snyder, 1989; Monteverde & Teece, 1982; Spiller, 1985) and uncertainty (MacMillan, Hambrick, & Pennings, 1986; Walker & Weber, 1984) have been analyzed as independent variables and tested in several works about the determinants of vertical integration. Specifically, managers’ perceptions of an asset nonsalvageability have been adopted as proxy of the degree of its uniqueness or specificity (Masten et al., 1989; Walker & Poppo, 1991). Similarly, uncertainty can be measured as managers’ perceptions of the extent to which they can contractually specify forecasts, schedules, and other conditions, in advance (Poppo, 2003).

10 As Williamson (1992) himself has noted ‘ transaction cost economics need to be tested empirically’. Issues related to testing the internalization theory of the multinational enterprise are discussed by Buckley (1988). 11 A review of the large body of empirical work in transaction cost economics is developed by Shelanski and Klein (1995), who provide a picture of the broad range of topics as well type of studies which directly test transaction cost economic hypotheses or have implications for transaction cost economics.

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Variable Levels

Products/services

Variables

Specificity (sunk costs)

P1 (–)

P2 (–) Uncertainty

Transactions P3 (+)

Internal market for intermediate goods/services

Inefficiency of the “captive market”

MNE’s strategic orientation

Need for flexibility

P4 (+)

Fig. 2. Factors affecting the establishment of an internal market for intermediate goods/services.

4.2. Market for charters A charter is a business or an activity for which a subsidiary has responsibility for the whole MNE (Galunic & Eisenhardt, 1996).12 The phenomenon of charters is relatively new and represents clear evidence of the fact that, in some cases, a subsidiary acts more like an equal partner of the parent company than a subordinate entity (Birkinshaw, 1996). Recent research (Birkinshaw & Hood, 1998; Galunic & Eisenhardt, 1996) points out that in the modern MNE subsidiaries compete with internal and external units both for new and existing charters. The functioning of such a market and the extent to which it could/should be established within an MNE require the following questions to be addressed: (1) To what extent are charters actually contestable? (2) What are the benefits/costs of an internal market for charters? Research building on the resource-based view can provide useful theoretical explanations for the analysis of this kind of market. The importance of resource- and capability-based approaches to the analysis of multinational strategies is largely acknowledged by literature (Andersen & Kheam, 1998; Fahy, 2002; Tallman & Lindquist, 2002). A modern multinational works like a global network of units characterized by different capabilities. When a resource-based approach is applied, a company profile is defined in terms of its resources and capabilities instead of markets served. From a resource-based perspective, the subsidiary capability to perform a world product mandate or charter relies on the availability of a bundle of firm-specific resources, which can build a competitive advantage in the achievement of that activity. Charters and resources/capabilities are two sides of the same coin in the sense that the endorsement of

12 The concept of corporate charter can be considered equivalent to that of world product mandate, even though the former broadens the definition of mandate including both single value-adding activities and entire businesses (Birkinshaw, 1996).

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specialized resources allows a subsidiary to take the responsibility to run a business or an activity for the whole MNE (Birkinshaw, Hood, & Jonsson, 1998). The contestability of a charter is related to the degree of mobility of its underlying resources and capabilities and, consequently, to the type of competitive advantage they allow to achieve (location-bound vs. nonlocation-bound) (Rugman & Verbeke, 1992, 2001). As far as resources and capabilities needed to fulfill a charter are nonlocation-bound (i.e. can be transferred across the MNE), charters are contestable. On the contrary, as far as underlying resources and capabilities are location-bound and country-specific, contestability is constrained. P5. Resource mobility (i.e. nonlocation-bound nature of resources) is positively related to the implementation of an internal market for charters. The testability of propositions (like this) building on a resource-based framework implies the need for the operationalization of resources’ characteristics. Generally, empirical studies rely on managers’ evaluations which are captured through items measured on Likert scales.13 Within the constraints given by the contestability of charters due to the location-bound nature of underlying resources and capabilities, the headquarters has some degrees of freedom in the implementation of an internal market for charters. Such implementation is related to multiple factors, which can be grouped in subsidiary-specific, headquarters-specific as well as factors concerning the parent company-subsidiary relationship. First of all, the effectiveness of an internal market depends on the subsidiary’s reputation or credibility in the eyes of the parent company (Birkinshaw & Hood, 1998). In fact, without the recognition of the importance of subsidiary specialized resources by the parent company, the subsidiary’s capability to compete for charters is merely potential. A firm’s reputation summarizes its past strategic actions (Weigelt & Camerer, 1988) and performance. Prior international responsibilities or world product mandates increase a subsidiary’s credibility and enhance support by the parent company in the evaluation of the possibility that a subsidiary can challenge an existing charter or bid for a new one. What matters for the functioning of the internal market for charters is how proven resources and capabilities are. Proven resources result from ‘a history of successful initiatives and an accumulation over time of specialized and valued capabilities’ (Birkinshaw, 1997, p. 219). As a result, reputation is hard to define in a purely static manner. This concept cannot be evaluated without taking into account an evolutionary component, as credibility results from the historical pattern of evolution of a subsidiary and is a premise for its future development. P6. Subsidiary strong track record is positively related to its capacity to compete for charters and, therefore, the implementation of an internal market for charters. Bounded rationality and uncertainty are crucial aspects related to the working of an internal market, especially in the case of charters. Ex ante bounded rationality characterizes the parent 13

A number of propositions grounded on resource-based theory have been tested especially in the field of diversification strategy. Few studies have shown that the resource-based theory has a wider range of application than just predicting the type of diversification strategy. As Anderson and Kheam (1998) have argued, concerning the use of resource-based theory to predict growth strategy, two different traditions can be identified. The first relates to the large stream of research on diversification strategy at corporate strategy level. To give one example, Chatterjee and Wernerfelt (1991) suggest that physical resources and intangible resources, which are believed to be quite inflexible, can be used to enter closely related markets, while relatively more unrelated diversification will be associated with financial resources. The other tradition focuses on the business strategy level. Here, the resource-based theory is used within the conversation of strategy analysis and strategy formulation process. Efforts within this tradition have been mainly to develop practical implications for management, with few empirical studies (Grant, 1991).

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company’s decisions: ‘bounded rationality constraints force MNE headquarters to allow autonomous initiatives of subsidiaries to flourish, expecting that profitable opportunities will be captured well beyond the headquarters’ own ex ante capabilities to understand or even to identify such opportunities themselves’ (Rugman & Verbeke, 2003, p. 134). Only ex-post corporate headquarters can understand how good the decision to encourage subsidiary initiatives or assign worldwide responsibilities was. Under conditions of high subsidiary’s external embeddedness and location-bound knowledge, it is more difficult for the headquarters to identify a subsidiary as a centre of excellence and implement a corporate strategy based on capabilities developed in different units of the MNE network. Therefore, centralized decisions made by the headquarters about the assignment of activities to the subsidiaries may not take into account subsidiary-specific capability profiles as much as market-like mechanisms would. In these cases market-like mechanisms of resource allocation, based on competition among the MNE’s units, would be more beneficial in terms of a fit between subsidiary-specific capabilities and activities performed. A greater decentralization of decision making processes is a necessary condition for the working of an internal market as it would provide subsidiaries with the degrees of freedom needed to pursue the strategic initiatives that better can exploit existing subsidiary-specific capabilities and build new ones (Birkinshaw & Hood, 1998). P7. Decentralized decision making is positively related to the implementation of an internal market for charters. On the other hand, market-like mechanisms may create a risk for distortion in the subsidiary pattern of development because the intent to affect the parent company’s decisions concerning the assignment of charters can bias the behaviour of subsidiary managers. Given the uncertainty related to investment decisions about charters, the parent company tends to consider subsidiary performance as a reasonable justification for the decision to assign a new charter or keep an existing one (Birkinshaw & Hood, 1998). Subsidiary track record lessens uncertainty perceived by the parent company. High track records may also induce less emphasis on formal control and higher degrees of autonomy, creating a virtuous self-reinforcing path. Therefore, Propositions 6 and 7 are strongly related as decentralization of decisions and subsidiary reputation/performance are linked to one another: in the case of poorly performing subsidiaries, there is more likely a greater involvement of corporate staff and limitation of subsidiaries’ autonomy in challenging existing charters. However, resource and capability accumulation is a costly process and in many cases (for example, R&D activities) the payoff of investments can slowly emerge over time. Interest in preserving existing charters may be an incentive for subsidiaries to prefer a short-term orientation, which can preserve short-term performance but weaken the subsidiary’s set of resources and capabilities in the long run. Such risk depends on the way the parent company evaluates subsidiary performance. In fact, subsidiary performance is a complex construct (Birkinshaw & Morrison, 1995), depending on the primary goals of the parent company. ‘New market entry, for example, is typically associated with negative returns in the first few years but the subsidiary manager would be expected to deliver on market share growth. A well-established subsidiary, in contrast, might be evaluated on contribution income or ROI’ (Birkinshaw & Morrison, 1995, p. 740). The evaluation of subsidiary initiatives cannot always be based uniquely on financial ratios or short-term criteria because specific investments to acquire new competencies in the long run are not captured by merely financial parameters. The potential for distortion in the subsidiary pattern of capability development, due to the risk for charter loss, represents a limitation associated with the extensive working of an internal market.

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Variable Levels

Variables

Charter

Resource mobility

Subsidiary

Strong track record

269

P5 (+)

P6 (+) Internal market for charters

Parent company

Decentralized decision making

P7 (+)

P8 (+)

Parent companysubsidiary relationship

Frequent and open communication

Fig. 3. Factors affecting the establishment of an internal market for charters.

Therefore, the quality of the relationship between parent company and subsidiary is essential to avoid the risk of bias in market mechanisms. The MNE can adopt a number of mechanisms for the governance of the relationship with subsidiaries, including traditional forms of bureaucratic control and coordination, socialization mechanisms, market-like tests of feasibility for new projects, the enhancement of informal communication channels. As Rugman and Verbeke (2003) maintain, the development of an ‘optimal set’ of control instruments is very much a firm-related problem. Among those mechanisms, openness and frequency of communication play a strategic role. Communication enhances the possibility for the subsidiary to give adequate explanations of strategic choices and receive timely feedback on their initiatives. Communication speeds the process by which the parent company acquires confidence about the subsidiary’s capability to perform activities successfully. Consequently, the level of trust in the subsidiary-headquarters relationship gets higher and the process of evaluation of subsidiary initiatives and performance by the parent company becomes less problematic (Rugman & Verbeke, 2001) (Fig. 3). A relationship based on frequent and open communication would: – allow the subsidiary to explain the value of their projects; – give the headquarters the opportunity to have as much as possible information to evaluate subsidiary initiatives. P8. Frequent and open communication are positively related to the implementation of an internal market for charters. 4.3. Market for practices and competencies The third kind of market is significantly different from the previous ones. The functioning of the markets for charters and for intermediate goods and services relies on the existence of

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competitive relationships within the MNE, while the market for competencies and practices is based on the existence of cooperation among subsidiaries. Learning is a social process which mainly occurs through interaction with other organizations. Price as traditional market-based governance device is less effective in this case. Therefore, the concept of market itself is misleading and not appropriate as the nonmarket (and noncompetitive) character of the MNE matters in the transfer of competencies and practices. The question of how and to what extent knowledge and capabilities can be transferred between different units is crucial for analysis of the MNE’s competitiveness. Research works drawing on organizational learning perspective and evolutionary theory (Kogut & Zander, 1993) provide useful theoretical insights for analysis of the transferability of practices and competencies. Leveraging competencies and practices across different nodes of the MNE allows the extraction of superior rents from specialized knowledge compared to the value created in the case such specialized knowledge is constrained within a single unit of the MNE. Knowledge is difficult to protect because of its nature as a public good (Buckley & Casson, 1976). Rugman (1981) identifies the reason for internalization in the failure of the market for information, pointing out that MNEs use internal market for the transmission of information. Moving from the perspective of firm as a social community, which specializes in the creation and transfer of knowledge, Kogut and Zander (1993) develop an evolutionary theory of the MNE. Their main point is that the MNE (in more general terms, the firm) has an advantage in transferring tacit knowledge from one unit to another compared to between independent units. The conclusion is similar to that provided by internalization theory, even if the argument behind that is substantially different. In fact, their theory shifts the focus from market failures and risk for opportunism, central in internalization theory, to the cooperative structures that originate a set of capabilities which are easier to transfer within the firm than across organizations. Knowledge transfer among different units requires sunk costs, which depend on the specific characteristics of knowledge. This issue is addressed by Szulanski (1996): he highlights the problem of internal stickiness which negatively affects interunit knowledge transfer. Similarly, Nelson and Winter (1982) argue that interunit replication of routines is a costly process. A significant stream of literature deals with the factors affecting knowledge transfer. The type and richness of transmission channels, the absorptive capacity of the receiver unit (Cohen & Levinthal, 1990; Lane & Lubatkin, 1998) and the overall quality of the relationship between sender and receiver (Schlegelmilch & Chini, 2003) have been identified as determinants of the feasibility and effectiveness of the transfer (Szulanski, 1996). Gupta and Govindarajan (2000) identify five factors which act as barriers/facilitators to knowledge transfer: value of the source unit’s knowledge stock; motivational disposition of the source unit to share knowledge; existence and richness of transmission channels; motivational disposition of the target unit to acquire knowledge; absorptive capacity of the target unit. Literature suggests there are different ways of describing knowledge. Most classifications are based on the ease/difficulty of transfer. For example, Winter (1987) maintains that four dimensions of knowledge are relevant: tacit/articulable, observable/not observable, simple/complex, independent/element of a system. Tacitness is a quality of knowledge that makes the transfer more complicated. Knowledge is implicit, associated with experience (Polanyi, 1966), not observable, complex and part of a system (Winter, 1987). All these characteristics are related to the concept of tacitness. The transfer of tacit knowledge is a costly process because it requires investments from the parties involved in order to make the knowledge understandable for the received unit. Zander and Kogut (1995) find that the degree to which capabilities are teachable and codifiable is positively related to the speed of transfer. Therefore,

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P9. Tacitness of knowledge is negatively related to the implementation of an internal market for knowledge and competencies. Tacitness is also related to the concept of context specificity. The ease of knowledge transfer depends on the source of the knowledge itself. For example, the complex interaction between a subsidiary and its local environment generates a kind of knowledge that cannot be exploited away from that specific context. Foss and Pedersen (2002, p. 64) highlight that ‘the context specificity of the knowledge has an effect on the extent of knowledge transfer, both because the more context specific the knowledge is, the smaller the absorptive capacity of the received and the less it can be used in other MNC units’. Therefore, ‘there is a trade-off between embeddedness and the possibility to transfer knowledge to other corporate units’ (Andersson et al., 2002, p. 985). In addition, even when possible, the transfer of knowledge-based resources always requires a process of adjustment that makes them firm-specific and embedded into a new set of resources. Consequently, the value of knowledge can be very limited when leveraged in a different context if not connected with complementary assets and learning capabilities in the subsidiaries (Rugman & Verbeke, 2003). In different terms, nonlocation-bound resources have to be complemented with location-bound resources. P10. Context-specificity is negatively related to the implementation of an internal market for knowledge and competencies. The testability of these propositions raises the issue of the measure of knowledge characteristics. Empirical research could rely on the use of multiple-item scales to measure the constructs that identify knowledge characteristics. Specifically, the construct of tacitness has been operationalized by Kogut and Zander (1993): they identify complexity, noncodifiability and nonteachability as three dimensions of tacitness. Gupta and Govindarajan (1991) argue that the complex global/transnational MNE is characterized by multidirectional flows of products, capital and knowledge among subsidiaries located in different countries. Interactions depend on the level of interdependencies between the MNE’s units. Greater interdependence in terms of flows of product/services enhances the transfer of knowledge. In fact, any exchange of products and services implies a flow of knowledge as knowledge is always somewhat embodied in products and services (Foss & Pedersen, 2002). P11. Interactions due to flows of products and services are positively related to the implementation of an internal market for knowledge and competencies. The existence of multiple learning paths within the MNE does not imply that the role of the parent company in the transfer of knowledge within the MNE has lower importance than in the past. In a recent study Gupta and Govindarajan (2000) point out that knowledge flows from parent company to subsidiaries are still considerable. The parent company plays a key role in stimulating the mobility of knowledge-based resources and facilitating the integration of different forms of localized knowledge, given its centrality in the network (Burt, 1992). However, the parent company-subsidiary relationship is undergoing a modification, in terms of governance mechanisms: rather than being characterized by hierarchy and bureaucratic control, such relationship is increasingly characterized by mutual interdependence and learning (O’Donnell, 2000). Therefore, the issue is to manage such interdependencies through a set of formal and informal processes and organizational tools, which take into account the variety of

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Variable Levels

Variables Tacitness P9 (–)

Knowledgespecific Contextspecificity

P10 (–) Internal market for knowledge and competencies

Sender unitreceiver unit relationship

Interactions due to exchanges of products/ services

P11 (+)

P12 (+) Frequent and open communication

Fig. 4. Factors affecting the establishment of an internal market for knowledge and competencies.

roles played by subsidiaries (Tseng, Yu, & Seetoo, 2002) and the extent to which transnational capabilities can be identified within the MNE (Rugman & Verbeke, 2003). As in the market for charters, the level and quality of communication among the MNE’s units is a critical condition for the implementation of a market for practices and capabilities. Communication builds trust and facilitates the sharing of tacit knowledge. A variety of organizational linkages and coordination mechanisms should be adopted so as to enhance frequent and open communication. Examples of such mechanisms are the creation of informal crossborder units so as to foster the sharing of the information and the enhancement of information management systems in order to implement a common platform, which can serve as a communication channel (Fig. 4). P12. Frequent and open communication are positively related to the implementation of an internal market for knowledge and competencies.

5. Conclusions This paper critically revises and expands Birkinshaw’s (2000) model of the MNE as an internal market system. Theoretical assumptions and implications of the model, which are not covered in its original formulation, are discussed in the study. It advances Birkinshaw’s model in two basic respects: 1. The analysis of the internal market model is deepened through positioning it within existing literature so as to explore its linkages with different theoretical perspectives of the MNE.

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Specifically, the discussion of the model is embodied in the modern network-based perspectives of the MNE. The analysis of the coordination mechanisms within the MNE network, made of a number of dispersed and interdependent subsidiaries, is an increasingly relevant research issue. By developing a stronger theoretical basis of the internal market model and focusing on the logic behind internal competition in the modern network-based MNE, this study provides a contribution within that stream of literature. 2. This paper advances Birkinshaw’s identification of three kinds of internal market (one for intermediate goods and services, one for charters, and one for practices and competencies), through the analysis of the factors which affect the creation and working of internal markets. I demonstrate that literature on internalization theory, resource based view, and organizational learning can help us understand when we would expect to see the three different types of internal market within an MNE. Two further considerations are to be pointed out, which can be viewed as both limitations of the study and directions for future research. Firstly, the set of propositions does not explicitly take into account an evolutionary component. The factors described in the paper as affecting the extension of an internal market and (consequently) the propositions developed might change depending on the stage of internationalization of the firm. Hence, the analysis could be further expanded by taking into account the issues related to an evolutionary perspective. Secondly, though useful for analytical purposes, the distinction between the three markets does not entail that connections and commonalities among them cannot be identified. Moreover, in the context of international business research, the three theoretical perspectives adopted for the analysis of internal markets are not to be intended as separate approaches, but as providing complementary contributions to a modern theory of the MNE (Rugman & Verbeke, 2003). In other words, there are strategic issues which affect the three markets as a whole. For example, flows of products and services go along with knowledge flows. The effective working of an internal market can be reduced because of the stickiness of existing relationships within the MNE (Birkinshaw et al., 1998). Stickiness does not characterize only knowledge transfer (Szulanski, 1996) but also refers to the market for charters or intermediate goods and services. For example, other factors being constant, it can be difficult to switch from one internal supplier of a given intermediate product to another just because the former has always carried out that activity. Therefore, the choice of the same supplier can assume the characteristic of a routine rather than a decision which is renewed periodically. The same point applies to charters: the fact that a subsidiary has fulfilled a specific charter for a long time can lead the parent company to preserve stability and confirm that assignment for the future. Finally, future research could also focus on the normative rather than theoretical side of the model and its implications for management, for example, by applying this theoretical lens to the analysis of case studies. Acknowledgements I am particularly grateful to Professor Alan Rugman for his encouragement and thoughtful comments on an earlier draft of the paper. I would also like to thank the editor, Professor Pervez Ghauri, and two anonymous reviewers for their valuable suggestions.

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